Penalty clauses

Acritical issue for contract law is what remedies are available to a party in the event that the other party breaches the contract. Remedies for breach may be available by operation of the law (i.e. irrespective of whether the remedies are expressed in the contract). An example of a remedy that is available by operation of law is an award of damages – or monetary compensation – to cover loss that is incurred by the innocent party as a result of the breach by the other party.

In common law jurisdictions, damages for breach of contract are said to be “available as of right”. In other words, a court does not have any discretion in determining whether damages should be awarded. Provided that the innocent party can prove the breach and the loss that it has incurred, it will be entitled to damages. By contrast, remedies that are recognized “in equity” are discretionary in nature, and only awarded where the court considers that they are justified by the circumstances, and where damages would be inadequate.

Examples of remedies that are recognized “in equity” are an order for specific performance, requiring the defendant to perform a contract, and an order for an injunction, requiring the defendant to refrain from doing something (for a further discussion about that body of law that is referred to as “equity” in common law jurisdictions, see China Business Law Journal volume 3 issue 5: Law or equity?).

Unlike the law in common law jurisdictions, Chinese law appears to give equal weight to damages and specific performance, as reflected in article 107 of the Contract Law, and does not appear to have a formal preference for either.

Alternatively, remedies for breach may be contractually agreed and form part of the “private ordering” of the parties. An example of this is where the parties agree that in the event that one party breaches a provision in the contract, the breaching party will have an obligation to pay an agreed amount of money, usually referred to as “liquidated damages”, to the other party. Similarly, the breach may trigger a variation in the amount of a payment that one party is required to make to the other party (e.g. a decrease in the purchase price for an asset where the vendor breaches the contract). The breach may also result in the forfeiture or deprivation of property or rights of the breaching party (e.g. the loss of a deposit that has been paid or the cancellation of contractual rights).

There are many different reasons why such contractual remedies are agreed. For example, the party who has the benefit of obligations owing by the other party may be motivated by the desire to deter the other party from breaching the contract or, to put it in positive terms, the desire to encourage or induce the other party to perform its obligations. In this context, the contractual remedy operates along similar lines to a penalty (or an inducement if considered in positive terms) and may not bear any relationship to the loss that would be caused by the breach or the amount that would be required to compensate for that loss. Alternatively, the contractual remedy may represent a pre-estimate of the loss that the innocent party would incur as a result of the breach of the obligation and operate in the nature of compensation.

In this respect, a critical issue for contract law is whether the law (or the courts) should refuse to recognize and enforce a contractual remedy on the basis that it is excessive or disproportionate to the loss that the innocent party has suffered, or the damages or compensation to which the innocent party would otherwise be entitled.

In common law jurisdictions, the law has traditionally looked unfavourably on “penalty clauses” that are intended to punish or penalize the party in breach and has developed a rule called the “penalty rule”, under which a court will either refuse to enforce such a clause or will limit the amount payable to an amount that would compensate the other party for the loss that it has incurred.

By contrast, the attitude towards such clauses in civil law jurisdictions and China is more relaxed. Instead of focusing on the “penal” nature of such clauses and invalidating them on this basis, these jurisdictions focus on whether the penalty is excessive. If the penalty is considered to be manifestly excessive, the courts have the power to reduce the penalty. An important point of distinction between common law jurisdictions and civil law jurisdictions is that in some civil law jurisdictions, the courts do not have to consider the relationship between the penalty and the actual loss suffered by the innocent party.